Operating Margin → The operating profit ( EBIT) retained per dollar of sales after deducting cost of goods sold (COGS) and operating expenses (OpEx).Īll three of these new parts are extensions of the net profit margin calculation.Interest Burden → The extent to which interest expense impacts profits.Tax Burden → The proportion of profits retained post-taxes.To expand further upon the additional parts of this formula: There are two additional components in the 5-step equation as compared to the 3-step equation. Operating Margin = Operating Income ÷ Revenue.Interest Burden = Pre-Tax Income ÷ Operating Income.Financial Leverage Ratio = Average Total Assets ÷ Average Shareholders’ Equity.Tax Burden = Net Income ÷ Pre-Tax Income.The five ratio components of the 5-step DuPont formula are as follows: The company must strike the right balance between benefiting from debt financing but not placing excess leverage on the company, where the company’s cash flows are insufficient to handle all the debt obligations and are now at risk of default.Often called the “equity multiplier,” increasing the amount of debt to benefit from the lower taxes, the lower cost of capital, and obtaining access to a cheaper funding source could easily backfire from irresponsible decision-making – hence, the company must be led by a management team with their interests aligned with that of its shareholders.However, interest expense is tax-deductible and creates a “tax shield” that reduces the amount of taxable income (EBT).The greater the reliance on debt financing, the higher the periodic interest expense owed to the lender, which causes the risk of default to rise.The third and final component, financial leverage, refers to the total amount of debt in the company’s capital structure.The starting point to arrive at these three components is the return on equity (ROE) formula.įinancial Leverage Ratio = Average Total Assets ÷ Average Shareholders Equity Financial Leverage Ratio = Average Total Assets ÷ Average Shareholders Equity.Asset Turnover = Revenue ÷ Average Total Assets.Net Profit Margin = Net Income ÷ Revenue.In the 3-step DuPont model – the simpler version between the two approaches – the return on equity (ROE) is broken into three ratio components: The 3-step DuPont analysis model states that if the net profit margin, asset turnover, and financial leverage of a company are multiplied, the output is the company’s return on equity (ROE). Originally devised in the 1920s by Donaldson Brown at DuPont Corporation, the chemical company, the model is used to analyze the return on equity (ROE) as broken down into different parts in order to analyze the contribution of each part. DuPont Analysis is a framework used to break apart the underlying ratio components of the return on equity (ROE) metric to determine the strengths and weaknesses of a company.
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